Part of the problem with being an economist — besides having to don sunglasses and a fake beard to avoid throngs of adoring fans and marriage proposals when out in public — is that once you think about a particular economic issue in a certain way, it’s virtually impossible to shake that mindset. If some other economist is reaching a different conclusion with his preferred mental framework, you stubbornly cling to your own conclusion because “when I think about it this way” you seem to be right.
What’s really ironic is that many times, both frameworks are perfectly valid. The reason the two economists come up with opposite conclusions is that at least one of them is using his own framework (or model) in a sloppy way. He’s used it so much in the past, and always come up with a certain type of answer, that he doesn’t realize it can yield a different answer when one of its dials is turned.
In the present article I’ll go over two examples that illustrate this hazard of the occupation. First I’ll discuss a colossal blunder made by a big gun in the august pages of the Wall Street Journal. Then I’ll write about a much more painful topic, a case where I myself was (temporarily) led astray from an obvious conclusion, because my preferred framework hadn’t ever given me that type of outcome in the past.
Case One: Wolf Chooses Tax Hikes Over Currency Movements
Back in the December 15–16 (2007) weekend edition of the Wall Street Journal, Charles Wolf, Jr. wrote an op-ed titled “Our Misplaced Yuan Worries” (page A12). Wolf first lays out the “conventional wisdom,” which says that the US trade deficit with China would shrink if only the Chinese let their yuan appreciate against the dollar. This seems pretty straightforward: a relatively stronger yuan would lead the Chinese to buy more US goods (which now seem cheaper to them), while the relatively weaker dollar would lead Americans to buy fewer Chinese exports. In fact, this “conventional wisdom” is how economists teach currency markets and international trade flows to undergrads.
Yet Wolf thinks this is a very superficial analysis. To make sure we get his point, I’ll quote him extensively:
This reasoning, though plausible, is wrong. A country’s global current account deficit depends on the excess of its gross domestic investment over gross domestic savings. Gross savings in the U.S. are about 10%–12% of GDP [while] gross domestic investment is 16%–17% of GDP. The difference between the two comprises the U.S. current account deficit.
China’s current account surplus is the mirror image of the U.S. imbalance. Gross investment in China is above 30% of its GDP, but its savings are even higher, above 40%.
While the appreciation of the yuan might initially raise U.S. exports to China and lower China’s exports to the U.S., these effects would be small and transitory as long as the imbalances between savings and investment in the two economies persist.
Rather than revaluing the yuan, Wolf recommends possible strategies such as distributing credit cards in China, reducing US federal spending, and even “establishing a graduated consumption tax” in the United States. These types of policies would be better because “unlike currency realignment, they would actually address the underlying sources of the US and Chinese imbalances.”
The problem here is that Wolf is so enamored with thinking of current account deficits in terms of capital account surpluses, that he fails to see the validity in the alternate view of focusing on currency markets. Make no mistake; I too am a fan of Wolf’s framework. But the problem is that in this instance, his preferred framework has led him to the wrong conclusion, even though it contains the ability to yield the same answer that his opponents get.
Yes, it is true that if domestic investment exceeds domestic savings, then there must be a net inflow of capital, which is the flip side of a current account deficit. This accounting tautology trumps other things, even the incentives of currency movements. But in our present context, this is a bit like saying, “I don’t care if you put that block of ice in the oven. So long as its molecules don’t increase their random motion, it won’t melt. Please study some physics before talking to me in the future.”
What Wolf should think through is this: how are the Chinese currently holding down the yuan, relative to the dollar? It’s not that they’ve passed a law, enforced with guns and prison sentences. No, they’ve suppressed the yuan’s appreciation by massively buying US debt. To put it simplistically, the Chinese government takes some of its revenues (in yuan), and enters foreign currency markets to trade those yuan against US dollars. Then it uses the dollars to buy Treasury bonds from the US federal government. By having a huge agency offering yuan to buy billions of US dollars in the currency markets, the price of the dollar (measured in yuan) is propped up higher than it otherwise would be.
So what would happen if the Chinese government abandoned this practice? The obvious effect would be a fall in the yuan-price of dollars. But another immediate implication would be a reduction in investment in the United States, because buying Treasury securities counts as “investment” in these types of measures. Further, the lowered demand for US debt would lower its price, which is the same thing as saying that interest rates in the United States would rise. This would tend to raise domestic savings. Thus the US imbalance (of domestic investment exceeding domestic savings) would be reduced.
What of the Chinese side? Well, depending on what they did with those yuan (that previously were earmarked to buy US securities), the imbalance could be reduced as well. For example, if the Chinese government spent the yuan on roads or food stamps, then the gap between its savings versus investment would shrink. This is because spending on roads would increase investment, while spending on food stamps would increase consumption, which means reduced savings.
Case Two: Murphy (Briefly) Thinks Dollar Dump Can’t Cause Inflation
Just to show that I too am susceptible to this vice, let me explain the circumstances of how I was led astray. Many economists believe that the US dollar is poised to fall even further against other currencies. Some of the more alarmist in this camp warn their readers that if foreigners tire of holding these deteriorating dollar-denominated assets, they might decide the emperor has no clothes and stop treating the dollar as the modern era’s gold. If that were to happen, the warning goes, then US consumers would suffer massive spikes in the prices they pay at Wal-Mart (since imports from China would now be so expensive), and they would also suffer from huge spikes in interest rates (because of the expected inflation).
Although it sounds plausible, at first I had difficulty accepting the validity of the argument. Let me try to explain the source of the cognitive dissonance. As a free market economist, I was used to arguing that unions and OPEC couldn’t cause price inflation. Sure, Arab countries might jack up the price of oil, but then that would just leave less money for Americans to spend on other things. The only group of people, I loved to point out, that could raise dollar-prices in the long run were those running the Fed, since they controlled the supply of dollars.
So by the same token, wasn’t it inconsistent to now claim that foreigners could cause massive price inflation in the United States? After all, if people had to pay more for Chinese imports, wouldn’t that just leave less money to spend on haircuts from American stylists? Why would we expect prices in general to go up?
There are (at least) two ways to reconcile these contradictory intuitions. In other words, I still believe that the defense of OPEC and unions is right — i.e., they can’t unilaterally cause inflation — while I also believe that people warning against a dollar crash are right, i.e., that a sharp fall on the foreign exchanges could lead to massive inflation at home. Let me explain the two issues in turn.
First, it’s not quite right to say that only printing up more dollar bills can lead to higher price tags. There is always the subjective, demand side of the market. For a silly example, if Americans suddenly became convinced that powerful aliens would conquer the United States three months in the future, and that the aliens would kill anyone holding dollars, then the prices of items right now would shoot through the roof. People would try to shift their wealth out of dollars (and dollar-denominated assets) and into other liquid items, such as gold, diamonds, etc. This massive drop in the purchasing power of the dollar would not be the fault of the Fed (though we might blame the Pentagon for focusing on Iraq rather than those merciless Martians).
Second, and more relevant to our discussion, is the fact that the foreigners in question are demanding dollars in order to buy US assets, not US products. So even if we neglect the fact that a worldwide drop in the demand for dollars leads to higher prices (measured in dollars), we still see how US consumers could get fleeced. Above I asked, “Just because the price of Chinese imports goes up, why wouldn’t the price of other things go down?” Fair enough, but what if the compensating prices that are dropping are things like the price of a share of IBM, or the price of a federal Treasury bond? These movements would be totally consistent with doomsday predictions of massive spikes in the CPI, and high interest rates.
Conclusion
The areas of international trade, monetary theory, and finance are complicated enough when studied in isolation. But when you have to mix them all together, as the current economic crisis requires, it’s very easy to make a mistake in reasoning. One common source of error, as I’ve demonstrated above, is the use of tools that work very well in one setting, mistakenly deployed in a different setting. As with everything else in life, competition among conceptual frameworks is very healthy, since it can quickly highlight when an economist is likely abusing his favorite technique.
